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Question:

We already have an estate plan set up with a revocable trust. Roughly 50% of our liquid assets are in regular and Roth IRAs; we have been moving some funds from our regular to Roth IRAs for several years and hope that the Roth IRAs will pass to our two children upon our deaths. We have recently considered creating a irrevocable trust, funded with our non-IRA assets, with the goal of providing some small amount of income to future generations in perpetuity. We are thinking that we would allow the trust to grow for 15 years before making any distributions, that distributions would be 2-4% of the total value of the trust each year (with the expectation that a 5%-8% average return in broad based stock index funds would allow the trust to continue to grow in assets over time), and that funds would not be distributed to any beneficiary until they reached 30 years of age. We are concerned that the current 35% Federal tax rate plus Massachusetts income taxes and ~1% in trustee fees would significantly inhibit growth of the trust over time. Can you give us any advice on how we might accomplish our goals of providing some income to generations beyond our children and grandchildren?

Response:

It’s terrific that you’re in a position to create a lasting legacy for your family. You are right that both taxes and professional trustee fees can be a drag on trust investment returns. As you know, to the extent irrevocable trusts retain income, they will be taxed at the trust income tax rates, which accelerate much more quickly than the graduated rates for individual or married taxpayers. However, once the trusts start making distributions, the higher rates will end because the income for tax purposes will flow through to the beneficiaries who receive the income. A few thoughts on this:

First, you may want to wait to fund the trust until the death of the survivor of you so the income will continue to be taxed to you during your lives. (You can also create the trust and structure it as a grantor trust with the same tax results.) This has the further advantage of the trust assets receiving a step-up in basis at the death of the grantor. There are two potential drawbacks to this approach. First, it’s possible, however, that if the trust is not earning that much income, it will at least for some time be subject to a lower tax rate than you. Second, the trust assets will be in the estate of the survivor of you and your spouse, undoubtedly making it subject to the Massachusetts estate tax, if not the federal one. If you do fund the trust during your lives and its not a grantor trust, it will not be subject to the Massachusetts estate tax. In other words, there’s something of a trade off between the estate tax and the tax on capital gains.

Second, be aware that even though trust tax rates are accelerated, the investment portfolio may not in fact generate very much taxable income. If it’s entirely invested in shares of stock and they are held and not exchanged, then only the dividends will be taxed. The shares will only be taxed when and if they are liquidated. Further, certain trust expenses are deductible, including the professional trustee fee and the fee for preparing the annual trust income tax return.

Third, if your investment strategy is to invest in a broad range of ETFs to be held for a long time, perhaps you can reduce the trustee fee either by negotiating a lower fee, or having a family member or friend serve as trustee. While the trust is simply being held for future distributions, the responsibilities should be relatively light.

In any case, as you can see, there are a lot of moving parts here, including income taxes, taxes on capital gains, estate taxes, investment strategy, and trustee fees. You will have to meet with a qualified professional (or perhaps a small team) to determine the best approach.

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